How to value a commodity company?

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01/22/2019 | 11:04 pm
Mining companies - oil, gas, coal, gold, copper, diamonds, etc. - are risky: as resource prices can easily fluctuate a fivefold, their return on investment is uncertain. This is why the financial models that are being used to value this type of company are inaccurate at best and completely unrealistic at worst.

The business activity of mining companies also implies maximum leverage: once their development investments and operating costs are written off, any positive difference - or ‘netback’ - between the production cost and the selling price is directly reflected in the profits.

Conversely, when the price of the resource on the market is lower than its production cost, the losses increase sharply. In that case, the companies can’t rely on the mercy of their investors to absorb the shock and stand firm.

This warning being made, the author proposes below a simple intuitive model that’s rough on purpose - because it’s better to be roughly right than to be exactly wrong - in ten distinct stages to value a commodity producing company.

All the necessary information can be found in the annual reports which are available on the websites of the evaluated companies in the ‘investor relations’ section.

1. Isolate the following assets one by one: working capital (meaning the current assets minus the current liabilities, or the resources necessary for the operation of the business over the year), proven reserves, probable reserves, possible stakes in other companies, various assets like drilling equipment, pipelines, storage tanks, treatment plants, etc.

2. Isolate long-term liabilities - short-term liabilities have already been deducted when calculating the working capital - without forgetting to take into account any provisions for the rehabilitation of natural sites, sometimes recorded off balance sheet.

3. Because a safety margin is always welcome, count all assets as zero except for the proven reserves. However, and naturally, take the long-term liabilities into account for 100%.

4. Then calculate the operating breakeven - meaning the profitability threshold - of the business, starting with the extraction cost. Therefore, divide the total of operating expenses for the year - excluding non-cash expenses such as depreciation, but including financial charges - by the production for the year which will give you the extraction cost of each produced unit - a barrel of oil, a cubic meter of gas, a ton of coal, an ounce of gold, etc.

5. Then calculate the development cost - meaning the amount of long-term investments made to develop the production, or ‘capex’, short for capital expenditures - according to the same mechanism: by dividing the capex for the year by the production for the year, which will give you the development cost for each produced unit.

6. Add the extraction cost and the development cost: now you have the breakeven per produced unit, meaning the total cost of production per barrel of oil, cubic meter of gas, ton of coal, etc. Do the same calculations for the two or three previous years so as to outline an average. Don’t hesitate to retain the upper limit of said average in order to prevent any bad surprises.

7. Deduce the profitability of each produced unit from the various market prices. If, for example, the breakeven point of an oil producer - extraction cost plus development cost - is $60 per barrel, he or she will pocket $10 per barrel with a market price of $70, or $20 per barrel with a price of $80, etc.

8. As the fair value of an asset is equal to the sum of the profits it generates for its owner during its lifetime, you need to multiply the total of proven reserves - for example, 50 million barrels of oil - with the ‘netback’ pocketed per barrel according to the different selling prices. To continue with the same example, based on a breakeven of $60 per barrel and a selling price of $70, you need to multiply the netback of $10 with the 50 million of barrels in proven reserves: said reserves are worth $500 million if the oil price is $70 a barrel, or $1 billion if the oil price is $80, etc.

9. Subtract the value of the proven reserves of the total of long-term liabilities to obtain the net value of said reserves according to different selling prices.

10. Then compare this net value to the market capitalization of the evaluated company. If the market capitalization is lower than the obtained net value, there may be a potential investment opportunity to explore - because, at least on paper, we can acquire a direct stake in a producer for a price that underestimates the net value of the proven reserves: the rest of the reserves - all taken into account as zero - serve as an additional safety margin.

Once this valuation has been made, it's good to assess the company’s ability to survive: therefore you need to verify whether or not the leverage is reasonable - for example by checking that the debt doesn’t exceed two years of cash flows and that there is no pressing maturity date.

Of course, the model featured here is far from perfect: the operating expenses can increase, and by extension reduce the netback; also, the realized selling price varies from one year to another, and the valuation of the reserves has to be recalculated depending on depletion.

Investing in commodity companies is exceptionally tough and full of the unexpected which is why it’s something that should be reserved for specialists - or savvy speculators.

Neelie Verlinden
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